The Macroeconomic Implications of Rising Wage Inequality in the United States

Jonathan H. Heathcote, Georgetown University
Kjetil Storesletten, Oslo University
Giovanni L. Violante, New York University

Abstract

This paper explores the macroeconomic and welfare implications of the dramatic recent rise in wage inequality in the United States. Between 1967 and 1996 cross-sectional dispersion in earnings increased even more than dispersion in wages, due to a rise in the correlation between wages and hours worked. By contrast, inequality in hours worked remained roughly constant, and dispersion in consumption and wealth increased only modestly. The goal of the paper is to ask whether a calibrated overlapping-generations model with incomplete markets can account for these trends, and, if it can, to quantify their welfare effects. We first use PSID data to estimate a time-varying process for wage risk. This process is then used as in an input into our economic model to endogenously generate time variation in other dimensions of inequality. In a simulation we find that the model broadly replicates the set of facts described above. We find that the welfare costs of the rise in wage inequality are large: the ex-ante loss is equivalent to a five percent decline in lifetime income for the worst-affected cohorts.